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28 July 2017

28 July 2017

Investment markets and key developments over the past week

Share markets were soft over the last week. Eurozone shares rose 0.2%, US shares were flat despite good earnings news but Japanese shares fell 0.7%, Chinese shares fell 0.2% and Australian shares lost 0.4%. Bond yields generally rose but the main development was the continuing softness in the US dollar not helped by a dovish interpretation of the Fed and ongoing mayhem around the Trump Administration. This and rising commodity prices and saw the Australian dollar briefly rise above US$0.80 for the first time since May 2015.

The rising Australian dollar is not good for the Australian economy. Despite numerous attempts by the RBA to calm down interest rate hike expectations and lower than expected June quarter inflation the A$ continued its ascent over the last week. This in large part is a weak US$ story, with somewhat dovish comments from the Fed and the political noise (or should I say comedy, given the infighting and revolving team!) around President Trump not helping, but the rebound in commodity prices including a rise in the iron ore price to US$70/tonne is also contributing. Technical conditions are also playing a role with the break of the top of the US$0.72-0.78 range that prevailed over the last year or so attracting more buying into the A$. The rise in the A$ is a big problem for the Australian economy and is likely contributing to the continuing underperformance of the Australian share market compared to global shares. With mining investment still falling, the consumer under pressure and housing construction looking like it is at or close to peaking we need a contribution to growth from trade exposed sectors like tourism, higher education, manufacturing and farming but a rising A$ will work against that. Any tourist operator who was thinking of expanding must now be fearing that another run to parity is on the way which will destroy the flow for foreign tourists and send locals back to Disneyland for their holidays rather than to North Queensland or Tasmania. What’s more the strength in the A$ will only put more downwards pressure on inflation. All of which makes more RBA attempts to jawbone the A$ back down more likely.

In the short term the A$ could still have more upside, but this is not 2007 – don’t expect a return to parity. The A$ is overbought but the breaking of the A$ above key points of technical resistance could still attract more foreign buying pushing it even higher in the short term. However, this is not March 2007 when the A$ burst through US$0.80 on its way towards parity as Australia’s export prices were surging on the back of 10% plus growth in China and a lack of commodity supply, when the Australian economy was growing at 5% year on year, underlying inflation was 2.8% and on its way to 5% and the RBA was hiking in response. Now the upside in commodity prices is limited by slower growth in China and surging supply, the economy is far from booming, inflation is below target, the RBA is far from tightening and while the Fed may be slower than expected it is still likely to continue raising rates and start reversing quantitative easing. So a resumption of the falling interest rate differential between Australia and the US will likely push the A$ lower. So I remain of the view that at some point in the next year the A$ will fall back – but trying to get a handle on when that will be and from what level is not so easy.

The US soap opera around “reforming” Obamacare had another comeback only to die again. Our view remains that it’s too early to write off President Trump's tax reform agenda where there is greater agreement amongst Republicans. The White House and Congressional leaders released a statement highlighting principles for tax reform with a focus on lower tax rates.

There was sensible news from the Trump Administration in that current Fed Chair Janet Yellen is reported to be in the running for reappointment as Fed Chair along with President Trump’s chief economic adviser Gary Cohn. Yellen’s reappointment would likely cause less financial market volatility which would probably be in President Trump’s interest given the mayhem around him.

While it didn’t attract much attention, the IMF held stable its global growth forecasts for 2017 at 3.5% and 2018 at 3.6% following its latest review. This confirms a break with the last four years where forecasts were continuously revised down.

Major global economic events and implications

In the US, the Fed’s comments around inflation were a bit more dovish and its indication that it will begin allowing its balance sheet to rundown “relatively soon” left a bit of wiggle room as to timing. Our assessment is that with continuing solid US economic data the Fed is on track to announce the start of allowing its balance sheet to decline in September and will then hike rates again in December. A bout of uncertainty about whether Congress will raise the debt ceiling and continuing low inflation could delay this, but strong economic data is consistent with gradual Fed tightening.

And US data is good, with the past week seeing a rise in the Markit manufacturing conditions index, higher consumer confidence, continuing gains in home prices, a moderate rising trend in capital goods orders, a smaller goods trade deficit, ultra-low jobless claims and a bounce back in June quarter GDP growth to a 2.6% pace. Inflationary pressures remain soft though with another soft reading on employment costs.

US June quarter earnings results remain strong. Of the 288 S&P 500 companies to have reported so far 78% have beaten earnings expectations and 73% have beaten on revenue. Earnings could end up coming in around 12% yoy.

Eurozone business conditions PMIs remain strong and economic confidence is at a ten-year high.

Japan’s manufacturing conditions PMI fell a bit in July but remains solid, small business confidence rose, employment data was strong and household spending was much stronger than expected but core inflation remains stuck at zero.

Australian economic events and implications

Australian inflation remained low in the June quarter with both headline and underlying measures running below the RBA's 2-3% target. While government related prices in areas like utilities, health and education are seeing strong increases, private sector pricing power remains very weak. With growth running below trend, significant spare labour market capacity and now a rising A$ bearing down on import prices it’s likely that underlying inflation will remain below target for longer. So we remain of the view that the cash rate will be on hold for a lengthy period - at least out to late next year. In this regard a speech by RBA Governor Lowe added to the Deputy Governor a week ago in pushing back against expectations for an early rate hike in Australia. The Governor provided no sense of urgency to raise rates and reiterated that just because foreign central banks raise rates doesn't mean Australia will.

What to watch over the next week?

In the US, the focus will be on the July ISM manufacturing conditions index (Tuesday) which is expected to fall slightly but remain strong at around 56 and payroll employment (Friday) which is likely to show growth of around 180,000 with unemployment falling to 4.3%. Wages growth (also Friday) is likely to remain relatively soft though at around 2.4% year on year and core private consumption deflator inflation (Tuesday) is likely to remain soft at 1.4% yoy. US June quarter earnings results will also continue to flow.

Eurozone core inflation (Monday) for July is likely to have remained weak at around 1.1% yoy keeping the ECB relatively dovish even though June quarter GDP data (Tuesday) is expected to show a pickup in growth to 2.2% yoy.

Japanese industrial production for June (Monday) is expected to show a decent bounce after a fall in May.

Chinese business conditions PMIs to be released starting Monday are expected to show that business conditions remain reasonable consistent with growth remaining around 6.5-7%.

In Australia, the Reserve Bank (Tuesday) is expected to leave interest rates on hold for the 12th month in a row. While economic growth indicators have improved over the last few months and business confidence and jobs growth is solid, consumer spending remains at risk, housing construction is set to slow, inflation remains below target and is likely to remain so for longer given record low wages growth and the rise in the A$. As a result, the RBA is expected to remain on hold and reasonably neutral with respect to the outlook. The RBA’s latest quarterly Statement on Monetary Policy (Friday) may provide further clues on the outlook for interest rates but we expect rates to remain on hold out to late 2018 at least.

On the data front in Australia, expect credit growth (Monday) to remain moderate, CoreLogic data (Tuesday) to show a (concerning) further rebound in Sydney and Melbourne home price growth in July, building approvals (Wednesday) to have bounced back slightly but in a downtrend, a fall in the June trade surplus (Thursday) & flattish June retail sales (Friday) but a 1.3% gain in June quarter retail volumes.

The August profit reporting season will start in the week ahead with around 15 major companies reporting including Resmed, Rio, Suncorp and Downer. 2016-17 profits for the market as a whole are likely to have increased by around 18%, driven by a huge 135% gain in resources profits on the back of the rebound in commodity prices. Profit growth for the rest of the market is likely to be around 5.5% led by retailers, utilities, healthcare stocks and financials. As always in a low interest rate world dividends will be a key focus.

Outlook for markets

Shares remain vulnerable to a short term setback as we go through the weaker seasonal months out to October with risks around President Trump, North Korea, Chinese growth, central banks and the Australian economy all providing potential triggers. However, with valuations remaining okay – particularly outside of the US, global monetary conditions remaining easy & profits improving on the back of stronger global growth, we continue to see the broad 6-12 month trend in shares remaining up.

Low yields point to continuing low returns from sovereign bonds.

Unlisted commercial property and infrastructure are likely to continue benefitting from the ongoing search for yield, but this will wane eventually as bond yields trend higher.

National residential property price gains are expected to slow, as the heat comes out of Sydney and Melbourne.

Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 2.5%.

The A$ has pushed higher on the back of US$ weakness, higher commodity prices and technical pressure. While further short term upside is possible, our view remains that the downtrend in the A$ from 2011 will ultimately resume as the interest rate differential in favour of Australia is likely to continue to narrow (as the Fed hikes rates and the RBA holds).